What You Need to Know About Energy Stocks

A Foolish interview.

Henry Thoreau might not approve, but our modern lifestyle begets consumption: We require things to do work, eat, and live according to the standard to which we've become accustomed. Love or hate it, energy -- the dirty, fossil fuel variety -- is required to sustain these activities. And despite our efforts to break the addiction, we just can't.

In developed nations, that lends itself to stable demand for oil, natural gas, and coal. The voracious pace of development, increasingly materialist tendencies, and growing population of developing nations affords compelling growth prospects. Acquired at the right price, energy companies provide an opportunity to invest behind a compelling and rare theme: A recurring use product, with some mighty secular tailwinds.

It is in this spirit that I, an avid energy investor (at the right price), sat down with Million Dollar Portfolio Associate Advisor Charly Travers to chat about the MDP team's approach to energy investing, and whether he thinks dinosaurs would have preferred petrol or natural gas-fueled vehicles.

Mike Olsen: For reasons obvious, I'm a big fan of energy investments -- at the right price. As investors, I think we'd be wildly stupid to put our heads in the sand: Energy is a necessary element to the world's infrastructure, and we should profit by it. Talk to me about the MDP team's view on energy stocks within the context of a portfolio.

Charly Travers: Unless we want to revisit the days of living in log cabins and reading by candlelight, plentiful and cheap sources of energy are important. At MDP, we believe that the companies instrumental to these needs can be excellent investments. A properly diversified portfolio, for all investors, should include a handful of energy stocks, but only when, as you say, the price is right.

Olsen: Having followed the sector for a while, it's pretty clear that things can -- and do -- get ugly from time to time. Despite inevitability of demand, energy prices swing like a drunken movie star: The industry's cyclical, fixed costs are high, and it costs a lot to pull the stuff from the ground. Aside from the supermajors -- like ExxonMobil(NYSE: XOM), which you guys own -- profitability isn't exactly a guarantee. Can you tell me a thing or two about the qualities you guys seek in your energy investments?

Travers: The points you make are critically important for people thinking about investing in the industry to understand. This is an inherently challenging business for even the best operators, but for weaker players, some of the ugliness is self-inflicted through the deadly combination of excessive leverage, volatile commodity prices, and high production costs.

MDP is a relatively concentrated portfolio, so we have to pick the companies we own with extreme care. From the energy space we want companies that are low-cost producers, who are also in control of their own destiny. That typically means low debt, or at very least, manageable debt repayment terms.

Instead of being forced to sell assets at unattractive prices or dilute shareholders when times are tough, they have the financial strength to capitalize on the weakness of their competitors. These companies can create tremendous value for shareholders over time.

We've stayed away from leveraged [exploration and production companies] like SandRidge Energy(NYSE: SD). It may look cheap on the basis of its assets and potential, but because it has huge capital needs -- and is very indebted -- that potential cuts both ways. That's one of the reasons we sold our position in Chesapeake Energy(NYSE: CHK).

Olsen: That's good stuff. Can you talk about some of your holdings -- and maybe give a sneak peek on what we might expect?

Travers: Sure. Energy stocks currently make up 6.5% of our portfolio and we'd be interested in increasing our allocation a bit if and when the right opportunities present themselves. In addition to ExxonMobil, we own Denbury Resources(NYSE: DNR) and Devon Energy(NYSE: DVN) and we think both companies are good buys at current prices.

Denbury is the largest tertiary oil recovery company in the U.S. It owns Jackson Dome, which is the only naturally occurring carbon-dioxide deposit in the Southeast U.S. It uses this carbon dioxide to get oil out of mature fields at a very cost-effective price, which confers a significant competitive advantage.

After selling its international assets, Devon is primarily a domestic natural gas play with a balanced portfolio of conventional and shale properties. Devon also has a nice midstream business of storage facilities and pipelines.

Olsen: Those are great points. I'll put two more ideas in your ear: Kinder Morgan (NYSE: KMP) and Ultra Petroleum(NYSE: UPL). I wouldn't buy Kinder Morgan at current prices, despite a meaty yield. But I love the moat dynamics: Pipelines are tollgates and the cash flows are unbelievably predictable, which makes that dividend a virtual certainty.

I own Ultra Petroleum for a lot of the same reasons you guys own Devon. They've got unbelievably low-cost assets, a great management team, and they're about the closest thing to a pure-play natural gas E&P out there. Natural gas is in the gutter, and when it costs $5 to $7 to produce, $4 natural gas just can't persist indefinitely. I like those odds.

The Motley Fool's Million Dollar Portfolio is a real money portfolio that Charly and his fellow team members construct from the best opportunities in all of The Motley Fool's newsletters. Since its inception three years ago, Million Dollar Portfolio has outperformed its benchmark, the S&P 500, by more than 7 percentage points. The service is accepting new members for the first time in a year. If you're interested in finding out more, simply enter your email address in the box below.